Monetary Policy in the UK – The Framework and Current Issues Speech given by Kate Barker, Monetary Policy Committee, Bank of England At the National Association of Business Economics Policy Conference, Washington DC. 21 March 2005 I am extremely grateful to Rebecca Driver and Miles Parker for their research towards this speech, and to Peter Andrews, Charles Bean, Marian Bell, Rob Elder, Katie Farrant, Jennifer Greenslade, Lavan Mahadeva, Steve Nickell, Lea Paterson, Sally Reid, Sally Srinivasan, Jumana Salaheen, Alison Stuart and Jan Vlieghe, for their helpful and pertinent comments. Of course, this speech reflects my personal views. 1 All speeches are available online at www.bankofengland.co.uk/publications/Pages/speeches/default.aspx 2 Monetary Policy in the UK – the Framework and Current Issues Greetings. It is a great pleasure for me to have been invited over to discuss with you our approach to monetary policy in the UK. The UK system is still relatively young – just coming up to its eighth birthday. The key changes made in 1997 were to give the Bank of England operational independence to conduct monetary policy, and to specify a point inflation target. Initially somewhat controversial, central bank independence is now strongly and widely supported. Today, after a brief description of the key features of our framework, I will discuss some issues related to inflation targeting, and also look at the implications for monetary policy of recent trends in UK productivity. The UK’s inflation targeting framework The monetary policy framework put in place by the newly-elected Labour Government in May 1997 leaves the Government to set the inflation target, which is confirmed or changed annually in the finance minister’s Budget. It is a point target (presently 2%), and symmetric, so that we place equal weight on deviations in either direction. Decisions about the repo rate are taken monthly by a Monetary Policy Committee of nine individually accountable members. Each of our votes carries equal weight, and the votes are made public within two weeks of the policy announcement. In considering the rationale for this structure, it is important to take account of the background. From the mid-1970s, UK monetary policy pursued an unsteady course (Chart One), at different times based on money supply targets (variously defined), and on exchange rate targets (formal and informal). In 1992 sterling was forced out of the European Exchange Rate Mechanism, and subsequently a target was introduced to reduce inflation over the course of the 1992-97 parliament. This policy period was quite successful, but had some key drawbacks. Most significant among these was the continued suspicion that interest rate decisions, taken by the finance minister after consultation with the Bank of England Governor, reflected political considerations. The 1997 framework was a big step forward - clearly set up with permanence in mind, as demonstrated by the passing of the Bank of England Act. Previous monetary frameworks had changed at short notice, raising problems of time inconsistency (the suspicion that 3 governments will renege on monetary policy commitments for reasons of political expediency). The operational independence of the Bank is therefore crucial, but the need to ensure wide spread public support for central bank independence underpinned the decision, also welcome on other grounds, to retain political control over the target itself. Having a symmetric point inflation target means that there is now little room for uncertainty about what the MPC is seeking to achieve, making it relatively straightforward for us to be held to account by the Government, parliament more widely, and the public in general. For the business community, there is clarity over the background relevant to their own price and wage-setting. So this has been a sound framework within which the MPC has been able to establish and retain credibility. The evidence from financial market inflation expectations is that these fell sharply in 1997, and subsequently have remained broadly consistent with achieving the target (Chart Two). The MPC has been successful in meeting the target; over the 79 months in which our target was 2.5% based on the UK retail prices index excluding mortgage interest payments (RPIX), the average inflation rate was 2.4%. Also, inflation has never moved more than 1% either side of the target in any month (this is perhaps surprising, as more variability in inflation might have been expected due to supply shocks, and would not have indicated a policy failure). This success has been supported by a strong focus on transparency and communication. At the end of 2003, the MPC’s target was changed to 2%, but now based on the consumer prices index. Formula differences in the calculation of the CPI means that it is about 0.5% below RPIX. If this were all, there would be no effect on monetary policy even in the short- term. But it is a little more complex than that, as there are coverage differences, in particular that the CPI excludes housing costs, and over the long-term the difference is around 0.7%. The changeover has been successfully handled, and the fact that this was not a matter of much economic significance is well understood in financial markets. What are the issues for policymakers of operating with an inflation target? The use of inflation-targeting is certainly not without its critics – either generic criticisms of the whole approach, or relating to the particular remit and approach of an individual central bank. The following comments on some key points in this debate are based only on the framework and experience at the Bank of England, and in the time available cannot do full justice to the complexity of the question. 4 Inflation and output trade-off Initially, a criticism from both business and the wider public was that the primacy of the inflation target puts too little weight on output and unemployment. However, one success of our communication is that many businesses at least now understand better that in the long- term real variables will not be affected by the course of nominal developments. But of course since 1997 the UK economy has experienced continuous growth - whether this understanding would prove durable through any future period of sharp downturn is not clear. The UK framework and the MPC’s approach also enables output volatility to be taken into account when that is desirable. By tackling the remit in a forward-looking manner, focussing on prospects for inflation for the medium-term, we are able to allow the first-round, direct effects from shocks (such as big rises in the oil price, or changes in indirect taxation), to feed through to inflation, directing our focus at the possibility of second-round effects if the jump in the price level impacts on wages. In the instance of a deviation from target which is more than 1 percentage point away in either direction, the Governor is required to write to the Government setting out the MPC’s strategy for returning to target, providing an opportunity in these circumstances to clarify that we were seeking to avoid unnecessary output volatility (where this applies with smaller deviations a similar point would be made in the published minutes of the policy meeting). More technically, it is argued that the focus on inflation-targeting reduces flexibility and implies that real objectives are not incorporated in an optimal manner1. Certainly the MPC’s approach aims to be appropriately flexible, rather than overly rule-based. The response to a medium-term central forecast for inflation which is away from the target in either direction (based on the Committee’s views of the most likely economic projection), is not an automatic change in the repo rate. Rather, the risks to the outlook, and the question of whether a change should be delayed, will be considered. Often this will be embodied in the mean of the inflation forecast being away from the mode over the medium-term, as indeed it was during the February 2005 forecasting round. But my view would be that the MPC should be prepared to contemplate the mean of the forecast, around the two-year horizon, being away from the target if this were due primarily to a supply shock, and if the interest rate response needed to bring inflation to target more quickly would lead to significant output volatility. 1 See, for example, Woodford (2004) 5 Can these trade-offs, and the role of goals other than inflation, be communicated clearly within the inflation targeting approach?2 It is argued that lack of clarity could weaken claims to policy transparency, and risks an undue focus on inflation as the only quantified target. With regard to the former, the variety of possible economic conjunctures and their associated risks make any attempt to specify trade-off rules in general terms a rather fruitless exercise. But the onus is indeed on the MPC to account for how and why output concerns have affected any particular decision. And while the latter is certainly a theoretical possibility, the distinction of demand and supply shocks in our thinking suggests that in the UK we are very conscious of the need to strike an appropriate trade-off. Potential conflicts with minimising output fluctuations There is another issue which might be thought of as a disadvantage of a precise target. In general, it is the case that one result of successful inflation targeting is to limit output fluctuations away from trend. But it is possible to imagine some conflicts. For example, in the UK, CPI inflation was more than 0.5 percentage points below target between July and October 2004. At the same time the economy was growing broadly around trend, and unemployment was at a historically low level.